- January 13, 2023
A question we’ve heard from many of you in recent months and weeks generally follows the theme of wondering how or why stock prices have recovered so much and so quickly since March, despite so much uncertainty and risk.
A personal note
I want to start this quarter’s review with a short personal story. Please excuse the indulgence, but I think it will provide some insight into some key perspectives that can help us as investors.
I am not one who has a story of learning about stocks and following them from an early age under the tutelage of an elder family member. I didn’t have my first exposure to financial markets until my Junior year of college in the year 2000. My accounting professor bought and sold shares of Intel during class one day and bragged that during his lecture he made enough to buy lunch (but failed to mention that the tax on short-term capital gains limited where he would be eating lunch).
At that moment, I went from a mediocre student still trying to find my way to an A student laser focused on what I wanted to study. I haven’t stopped since.
After that first exposure to financial markets at the height of the dot com bubble, I started working in the business shortly after the bursting of that bubble. I spent a few successful years analyzing financial statements and making stock recommendations. The next step was managing portfolios.
My transition to managing portfolios for clients took place in the midst of the run up to, and the after math of, the Great Financial Crisis. Still in my 20s I had already experienced two 50% declines in stock prices. One might think that a double gut-punch like that would turn someone off to a career in financial markets. I doubled down – finished my Chartered Financial Analyst (CFA) designation and broadened my knowledge about the inner workings of business with an MBA.
The intent (hope, actually, in hindsight) was to be able to “explain”, or even control, through knowledge the market’s extremes I had witnessed.
Fast forward to today
Three historic market events have occurred in the 20 or so years since I first learned about financial markets. From this experience and my study, I have learned a few simple things that stand out as universal truths.
- Markets can’t always be explained
- They can never be controlled
- Once numbers 1 and 2 are accepted, everything else becomes easier
Number 3 is important. It must go beyond a basic understanding of the difficulty to explain, and impossibility to control, markets. It must be truly accepted, if not fully embraced. This acceptance is what provides the necessary confidence to follow a plan when the real world gets a lot messier than what we’re taught about financial markets.
What we are taught
Investors are rational
A central assumption of market theory is that at all times, all investors are acting rational. That is, they are making optimal investment decisions to maximize their returns for their preferred level of risk.
Markets are efficient
This is to say the price of all financial instruments immediately reflects all known information; therefore, their price at any given moment must be an accurate representation of their value.
Stock prices track the economy
If GDP grows at X%, corporate earnings will grow at Y%, and leads to Z% return on stock investments. Seems pretty simple. Change the earnings variable to interest rates and you get yourself the return from bonds.
If “X” happens, “Y” will follow
There are many examples of this. A current example that might be on many of our minds is to say that if the economy is weak then stock prices will remain weak. If earnings decline, then stock prices decline. Or, if “money is printed”, then inflation will follow.
Some of these might be true in a controlled experiment, and to be sure, many of these examples do have elements of truth to them. However, there’s one key point to remember as we try to accept the difficulty of explaining, and impossibility of controlling, markets. Markets live in the messy real world that rarely resembles a controlled experiment.
What actually happens
We’re all human
Investors are not always rational. Rapidly declining stock prices amid a global health crisis are akin to a lion chasing us on the savannah. Our first instinct is survival rather than profit maximization.
Selling stocks and asking questions later is like climbing the first tree found to escape the lion. Getting down? Worry about that later. As much as we might like to think otherwise, no, the inner wiring of our brains has not evolved much beyond basic survival instinct when presented with a threat.
Markets are kinda, sorta, most of the time efficient, but they still can’t be predicted
Markets do immediately digest all available information. However, many different interpretations of that information make for a messy process when incorporating it into stock prices. This process can, in the short-term, cause prices to deviate from their actual value, briefly and significantly.
Despite these temporary break downs, I would love to hear from anyone who, in the slightest degree, accurately predicted the path of stock prices in the first six months of 2020.
Stock prices track the economy – over the long-term
This might be the most perplexing concept of all right now. How can economic conditions be so uncertain and yet the S&P 500 is only down 4% in 2020? To quote a refrain from the book “Factfulness” by Hans Rosling, “things can still be bad but getting better”, which accounts for much of the recovery in stock prices. After a while, the “getting better” will result in things becoming good and higher stock prices tend to then reflect those better and ultimately good data. But its often hard to see small improvements in the moment.
It’s also important to keep in mind that the S&P 500 is not the entire stock market. Many other categories of stocks represent different pockets of the domestic and global economies and some remain down 10% to 20% so far in 2020. A diversified portfolio consisting of all corners of the world is still down about 10% on the year.
Markets are biological, not mechanical systems
Markets are shaped by millions of participants with individual motivations, incentives, and interpretations of data. This causes the path of markets to resemble a gravel country road with potholes, a downed tree, and a river crossing versus an interstate highway.
Both will get you to a destination, but you’ll need more confidence in your GPS, driving skills, and vehicle in the former. And even with that, you’re still likely to second guess your route and whether the destination is worth it. As a reminder, the destination is worth it.
What to do about it
Have a plan that is focused on your goals and resources rather than market returns, and, that incorporates periodic setbacks. This plan will provide perspective when markets don’t make sense (note: markets rarely make sense at any given time; during 2019 the often-repeated line was, “this doesn’t make sense, stocks can’t keep going up like this”). A thoughtful plan will reduce the desire to explain or control markets and help prevent running away from the proverbial lion on the savannah.
Your financial success is about more than your portfolio. The last few months have proven to be an excellent time to refinance a mortgage as interest rates have come down. This action lasts the rest of the time of your mortgage and may help pay it off sooner or free up additional cash flow to save, invest or have more fun.
For many, the last few months have highlighted the need to have sufficient cash savings – to bridge across an income disruption, take advantage of lower stock prices, or ensure that short-term goals can still be covered. It has also highlighted the value of having specific saving or investing plans for different goals, such as college tuition.
Thoughts on the recovery in stock prices
Let me first caveat this section by saying that, despite the rapid recovery in stocks since late March, it is too early to call a victory. Economic and health realities remain unsettled and are likely to stay that way for some time. In light of what we have experienced, it is natural to wonder how stock prices have recovered so much given the risks that remain. There are two different ways to think about this: the numbers and the behavior.
As things continue to remain bad, but, for the time being anyway, are no longer getting worse, we can start to make some reasonable assumptions about what stocks might actually be worth. For this, we turn to Aswath Damodaran, an NYU Professor of Finance who is often considered the academic community’s authority on valuing companies. He literally wrote the book on the topic.
In early June, his analysis of S&P 500 companies assumed a relatively conservative return to trendline earnings growth in 2024, with a range of potential paths earnings may follow to reach that level. The 50th percentile of his analysis arrived at a current fair value of the S&P 500 of 2,932. It closed the second quarter at 3,100 – in line with his 70th percentile estimate.
If indiscriminate selling of stocks is akin to running away from the lion on the savannah for survival, then what we have seen in the recovery is akin to feasting beyond the point of being full when survival is at stake. In modern terms, this is referred to as FOMO, or the Fear Of Missing Out.
Regardless of whether it has been the numbers or the behavior that has been responsible for driving stock prices higher, a basic script has been followed since the closing days of February. Stock prices declined as risk increased, leading to factors that drove bond prices higher before reaching a point when stock prices no longer needed to go lower, at which point they began to rise.
But it’s hard to follow the script when it seems to be a little different every time, even though the core plot lines remain intact. This is why we need to avoid trying to explain or control everything that is happening and remain focused on our plan.
When we look beyond the first six months of 2020, we see a longer story told by economic growth and recessions and stock price growth and declines. Going back to my personal story that started this, I entered this business in the spring of 2003 only a few months after the bottom of the dot com bust and the start of what became “the lost decade” for the S&P 500.
A lot has happened since then. International stocks did great for a while. So did US Small Cap stocks. Then when the S&P 500 was effectively written off as being “so ‘90s”, it began to surge.
There was the Great Financial Crisis and now a global pandemic. Along the way, a diversified stock portfolio returned almost 9% per year. All we had to do was keep owning them. That was certainly harder at times than others. But a thoughtful plan helped avoid the need to explain, control, or even avoid stocks along the way.